The Human Factor in Evidence-Based Investing

Welcome to the next installment of Escient Financial’s series on Evidence-Based Investment Insights:The Human Factor in Evidence-Based Investing

The last piece, “What Has Evidence-Based Investing Done for Me Lately?," wrapped up the conversation about ways to employ stock and bond market factors within a disciplined investment strategy, as well as how to extract the diamonds of promising new evidence-based insights from the larger piles of misinformation. Now it's time for the final and arguably most significant factor in your evidence-based investment strategy: the human factor. In short, your own impulsive reactions to market events can easily trump any other market challenges you face.

Exploring the Human Factor

Despite everything we know about efficient capital markets and all the solid evidence available to guide our rational decisions … we’re still human. We’ve got things going on in our heads that have nothing to do with solid evidence and rational decisions – a brew of chemically generated instincts and emotions that spur us to leap long before we have time to look.

Rapid reflexes often serve us well. Our prehistoric ancestors depended on snap decisions when responding to predator and prey. Today, our child’s cry still brings us running without pause to think; his or her laughter elicits an instant outpouring of love (and oxytocin).

But in finance, where the coolest heads prevail, many of our base instincts cause more harm than good. If you don’t know they’re happening or don’t manage them when they do, your brain signals can trick you into believing you’re making entirely rational decisions when you are in fact being overpowered by ill-placed, survival of the fittest reactions.

Put another way by neurologist and financial advisor William J. Bernstein, MD, PhD, “Human nature turns out to be a virtual Petrie dish of financially pathologic behavior.” [Source]

Behavioral Finance, Human Finance

To study the relationships between our heads and our financial health, there is another field of evidence-based inquiry known as behavioral finance. What happens when we stir up that Petrie dish of financial pathogens? The was previously delved deeper into deeper with the previous behavioral finance series, "Behavioral Biases series."

Wall Street Journal columnist Jason Zweig’s “Your Money and Your Brain” provides a good guided tour of the findings, describing both the behaviors themselves as well as what is happening inside our heads to generate them. To name a couple of the most obvious examples:

• When markets tumble – Your brain’s amygdala floods your bloodstream with corticosterone. Fear clutches at your stomach and every instinct points the needle to “Sell!”
• When markets unexpectedly soar – Your brain’s reflexive nucleus accumbens fires up within the nether regions of your frontal lobe. Greed grabs you by the collar, convincing you that you had best act soon if you want to seize the day. “Buy!”

An Advisor’s Greatest Role: Managing the Human Factor

Beyond such market-timing instincts that lead you astray, your brain cooks up plenty of other insidious biases to overly influence your investment activities. To name a few, there’s confirmation bias, hindsight bias, recency, overconfidence, loss aversion, sunken costs, and herd mentality.

Your Take-Home

Managing the human factor in investing is another way an evidence-based financial practitioner can add value. Zweig observes, “Neuroeconomics shows that you will get the best results when you harness your emotions, not when you strangle them.” By spotting when investors are falling prey to a behavioral bias, we can hold up an evidence-based mirror for them, so they can see it too. The next piece explores some of the more potent behavioral foibles investors face.

In the meantime, feel free to...